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The Roth 401(k): A Good Thing Has Gotten Better

See whether the Roth 401(k) makes sense for you.

The Roth 401(k) is stronger in some ways than the traditional 401(k). Photo: Flickr user Hector Alejandro,

Many of us are able to save for retirement via 401(k) plans through our workplace. That's a great benefit, since so few people these days are in line for a pension. There's a relatively new kind of 401(k) around now, and your employer may offer it or may soon offer it. It's the Roth 401(k), and it can turbocharge your retirement savings.

First, a little background. The traditional 401(k) plan was created by Congress in 1978, offering investors some welcome benefits. Like IRAs, both the traditional and Roth kinds, it lets you save money for retirement in a tax-advantaged way, though your contributions are limited. But whereas you can only contribute up to $5,500 to an IRA for the 2014 and the 2015 tax years (plus a $1,000 "catch-up" contribution to either if you're 50 or older), you can contribute a lot more to a 401(k). The 401(k) limit is $17,500 for 2014 and $18,000 for 2015, with respective catch-up contributions of $5,500 and $6,000 allowed, too.

The traditional 401(k) works much like a traditional IRA, in terms of taxation. You fund it with pre-tax dollars, thereby reducing your taxable income. In a simplified example, if your taxable income is $50,000 and you contribute $5,000, your taxable income falls to $45,000, reducing your tax burden. In a 25% tax bracket, you'd save $1,250.

That may seem terrific, but when you ultimately withdraw your money in retirement, it will be taxed -- and at your income tax rate, too, which could be considerably higher than the 15% haircut most of us get on long-term capital gains from investments.

That's why many people love the Roth IRA. With it, you contribute money on a post-tax basis, meaning that you get no upfront tax break. Have $50,000 in taxable income and contribute $5,000? Your taxable income is still $50,000. But... if you follow the rules, when you withdraw your money, it will all be tax-free. See the appeal?

Thus, many favor the Roth IRA but have been frustrated that the contribution limit to it is relatively low.

The Roth 401(k)

Enter the Roth 401(k), in 2006. Since that year, employers have been able to offer a Roth version of the 401(k) to their workers, and they've increasingly been doing so. According to Aon Hewitt data, only about 11% of employers offered the option in 2007, whereas fully 50% of them did in 2013, up from 40% just two years earlier. The same study notes that once they're made available, the percentage of employees participating in Roth 401(k)s rises in successive years, with companies that have offered the option for seven or more years seeing participation rates top 18%, on average. In addition, it's younger workers who are taking advantage of it most. That's perfect, because they have the most time for their investments to grow, and are thus able to build bigger retirement war chests -- which they can enjoy tax-free.

Benefits and drawbacks

Roth 401(k)s offer both pluses and minuses. On the plus side, many employers offer matching funds for your account, which amounts to free money. That's hard to beat, and whether your 401(k) is a traditional or Roth kind, it's worth contributing at least enough to max out the match. A typical match is 50% of your contributions, up to 6% of your income, meaning that if you earn $50,000 and contribute $3,000, your employer will chip in another $1,500. Plenty of employers are more generous than that, too.

On the other hand, whereas IRAs can be set up at brokerages where you can invest in just about any stock or fund, among other choices, 401(k) investment menus are generally far more limited, with many offering just a handful of mutual funds and the average plan offering about 25. (Still, a simple low-cost index fund or two is really all many of us need for our portfolios, as it will usually outperform most managed funds.)

If your employer offers a Roth 401(k), you should consider signing up for it, and if your employer doesn't, perhaps ask that the folks in charge consider adding it.

Author

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter... Follow @SelenaMaranjian